What’s a Subscription Software Company Worth?

By Aarthi Rayapura • August 11, 2014

The Information kindly allowed us to reprint this excellent piece by Katie Benner on the metrics behind making an informed SaaS valuation.

By Katie Benner

If you remember Enron, Worldcom and the dot-com 1.0 preference for eyeballs over revenue, you can understand why people are wary about the unfamiliar accounting metrics used to justify big valuations for subscription software companies.

Salesforce.com, Jive Software, Dropbox and Evernote don’t need profits to be worth billions, the thinking goes, because their value is underpinned by a set of numbers different from traditional earnings and revenue metrics. Company executives say it’s more important to focus on annual recurring revenue, margins, customer acquisition cost and the lifetime value of a customer.

With companies placing much more importance on projected revenue than on past performance, it’s no wonder so many cloud executives are optimistic on earnings calls.

But for all the fuss, subscription businesses aren’t new. The alternative metrics used to value them are pretty straightforward. And as more software-as-a-service (SaaS) companies go public, investors will have to understand them to make smart bets.

The idea that SaaS companies shouldn’t be evaluated on conventional earnings measures isn’t an obvious one. Telcos and cable companies have long depended on monthly recurring revenue, and the bottom line is as important to those businesses as acquisition costs, margins and recurring revenue. “The primary difference in my opinion is that [telecom and cable companies] are well into their mature growth phases,” says Richard Davis, a software analyst at Canaccord Genuity.

When cable companies were growth stocks in the 1980’s, investors complained that the firms never made money, and skeptics said they never would. “[They] were wrong because once you reach scale, a subscription model—especially in software—is not very complicated so the margins naturally will rise rapidly,” Mr. Davis adds.

The issue isn’t that Wall Street doesn’t understand SaaS models. It’s that, in the absence of substantial track records, one must rely on alternative metrics to identify which businesses can sustain revenue growth and profitability.

“There are good and bad subscription businesses,” says Michael Volpi, a partner at Index Ventures who invests in cloud companies. He and others in the business explain the most important metrics for subscription services with three questions: How expensive is it to make the product? How expensive is it to acquire revenue from a customer? And does that revenue stream last long enough to cover the acquisition cost and make money for the company?

While companies estimate the lifetime value of a customer, essentially a measure of churn, that number can fluctuate pretty wildly depending on how sticky the business.

The first part of the calculation looks at gross margin, a figure that shows what percent of overall sales is left after subtracting the cost to make the product. A 75% gross margin is generally considered a minimum for subscription software companies. Anything less means customers will have to be acquired very cheaply for the business to be healthy over the long run.

The second piece is a combination of customer acquisition cost and the recurring revenue from the customer. For example, if it costs $50 to acquire a customer and the annual recurring revenue is $50, that ratio is 1. “If the ratio is approximately 1, that’s pretty good,” says Mr. Volpi, since it means the customer pays for itself after just one year, and future revenue goes straight to the bottom line.

Whether a customer will stick around long enough to pay for itself, however, isn’t always easy to know; that can make SaaS accounting something of a leap of faith. Despite subscription renewal assumptions, a customer can leave anytime. That’s called churn, “the proverbial hole in the bucket that prevents growth,” says Zuora founder Tien Tzuo, whose company makes subscription management software. “If a company is at $100 million and wants to grow 30% but has 15% churn, they need to book 45% in new bookings to do so.”

Cloud companies combat churn with huge sales and marketing budgets. If you’re comfortable with that strategy, then you’re okay if a company spends, say, $2 to acquire $1 of revenue. Those numbers presuppose subscribers will stick around for at least three years, the amount of time it would take to come out ahead on each customer. “If the churn rate is sub 10%, that’s probably okay for a company like Box, [which spends more for customers than they’re worth in annual revenue],” says Mr. Volpi. “But if it’s 15% or more, the chances that the company will get a return on [its customer base] is very low.”

While companies estimate the lifetime value of a customer, essentially a measure of churn, that number can fluctuate pretty wildly depending on how sticky the business. Analysts think Salesforce.com is sticky because it holds lots of important data, businesses use it on an ongoing basis and they even build other products on top of it. But a company like communications app provider Jive Software, which can be used every once in awhile and doesn’t necessarily store data or key information, is considered less sticky.

Mr. Volpi adds that it’s good to get cautious when a company won’t give investors all of the data necessary to complete the above calculations. Salesforce.com has been investigated by the Securities & Exchange Commission for failing to disclose information that would let investors determine how fast different business lines are growing and how much of the revenue is driven by new versus returning business. (The SEC took no action against Salesforce, and the company told the commission that its fiscal year 2015 annual financial statement will break out what it calls “cloud-specific” revenue and other pricing trends.)

Box’s churn rate is unclear, making it hard to know whether or not the company is doing well. Publicly traded Zendesk reveals all of those relevant numbers in its annual filings.

During the last few years of unbridled exuberance, investors deemed the whole subscription software category a winner. But Wall Street took a more critical look at the sector during this spring’s selloff. The best performing stocks of the future should be those that give investors all the data they need to correctly analyze their businesses.